High-Stakes Bond Gamble Could Mean Higher Taxes : Finance: Lake Elsinore, with a population of 19,200, has authorized $500 million to spur new development.

High above the northbound lanes of Interstate 15, the fountains and waterfalls are working at the all-new Tuscany Hills development.

The otherwise hardscrabble hills are alive with sprinkler-fed shrubbery. Curbs and gutters for 2,000 homes are in. And all the amenities have been paid for--thanks to a $14.1-million Mello-Roos municipal bond issued last year by the city government.

But uncertainty looms at Tuscany Hills:

Only 125 of the 2,000 homes have actually been built. Just 50 homes have been sold, according to the mayor. And the ailing savings and loan that owns the remaining acreage has ceased its development operations because of orders from federal regulators.

So instead of having droves of new homeowners in place at Tuscany Hills, paying special property taxes to help retire the $14.1-million bond debt, Lake Elsinore is counting on reserves and a hoped-for economic rebound to sustain the project.

Otherwise, if the S&L; proves unable to make its special-tax payments, the city would have to foreclose on the land--and hope it could be sold quickly for enough money to cover the bond debt.

“I think the recession has hurt every major development,” said Lake Elsinore Mayor Gary M. Washburn.

Clearly, Tuscany Hills is an example of what records suggest is one of the most aggressive uses of municipal bond financing by any city in California. Lake Elsinore, population 19,200, has authorized the issuance of $500 million in municipal bonds. About $70 million has already been spent, beginning in summer, 1990.

“They’ve authorized an incredible amount of debt” in Lake Elsinore, said Stephen Shea, author of a recent California Debt Advisory Commission study of municipal bond financing.

Now, growth and prosperity in this arid city 70 miles southeast of Los Angeles hinges on the use and repayment of these bonds, bonds that are secured ultimately by raw and partially improved land--the value of which has been estimated by appraisers hired by the land developers.

Mayor Washburn and other leaders say the bonds are needed to attract home builders, to provide sewage and flood control for industry. They emphasize the city’s promise--the availability of spacious new homes at low prices, the convenience of Interstate 15, the eight-lane freeway leading to commuter destinations in five Southern California counties.

“There is tremendous development under way in Lake Elsinore,” said C. Ray Wood, the city’s municipal bond coordinator. “Some 20,000 residential units (are) either at some stage of planning or construction.”

The aggressive use of bond debt to foster development may work for Lake Elsinore. And if it does, the city will have defied municipal-finance authorities who warn against practices the city has used for Tuscany Hills and other projects.

Yet even if the risks are overcome, experts say Lake Elsinore’s methods will drive up the Mello-Roos taxes and related assessments imposed on new homeowners, who must repay the bond debt.

“It’s not clear that these (practices) will lead to financial ruin, but it will lead to taxpayers’ losing some of their money,” said Harry Clark, head of Muni Financial Services, a consulting firm based in nearby Temecula.

Lake Elsinore is one of a handful of cities in California using a complex form of bond financing that provides money to be tapped as development projects arise. It has worked this way:

The Lake Elsinore City Council and its Redevelopment Agency have created a cooperative that formed a pool of money by selling bonds to outside investors. Once formed, this “mother” pool, also called “Marks-Roos,” has purchased a subset of five “baby bonds” from the city.

Those baby bonds are of three varieties--tax-allocation bonds, assessment-district bonds, or Mello-Roos bonds--a name derived from one of the same lawmakers whose legislation authorizes the Marks-Roos pool.

Even skeptics concede that when used with tight controls, Marks-Roos can be a powerful tool, especially for small government agencies that might otherwise find it difficult to obtain municipal-bond financing.

But the inherent danger of Marks-Roos, they warn, is that it can encourage officials to embrace projects or developers who might not be financially worthy.

“It places a number of the incentives on the wrong side,” said Norman K. McPhail, an investment banker and former city manager who is based in Solana Beach. McPhail and others said the misplaced incentives can occur for two reasons:

Once a lump of Marks-Roos bond money is issued for a specific project, it must be spent--or repaid in full, typically within about three years. So, if a worthy project is not found and the bond proceeds are not actually spent, the money--including the funds already extracted for attorneys and other specialists--must be repaid to the bond investors.

Second, some cities, including Lake Elsinore, purchase their own “baby bonds,” at interest rates that enable those cities to actually make interest-rate profits.

The profits are generated by new homeowners, whose higher property taxes repay the baby bonds at an interest rate about 1% greater than the Marks-Roos, or “mother-bond” proceeds.

In Lake Elsinore, officials said they are aware of the pitfalls and are proceeding prudently.

“We feel very strongly about the security of what we’re doing,” Wood said. “And we’re trying to approach it very carefully.”

Interviews and records reviewed by The Times found that:

* Lake Elsinore’s bond-issuance procedures are indeed allowing it to capture interest-spread profits of nearly 1% on the bond proceeds. City leaders say they hope to reap $14 million or more of these profits over the next 25 years.

Wood said the profits could be spent for a new city hall, a park, “any capital-type project that the (City) Council felt they wanted to use it for.”

Critics see this money-making feature as unfair because the profits to be enjoyed by everyone in the city come at the expense of the new homeowners.

“It’s outrageous,” said Dean J. Misczynski, a policy consultant with the state Senate Office of Research. “It’s arbitrage in the sense of gouging an extra 1% from your own taxpayers. . . . If I was a homeowner, I’d be furious.”

Clark, whose consulting firm advises local governments throughout California, agreed.

“The public agency is solving their financing problems by making a profit on a small group of people,” Clark said. “From a public-policy standpoint, that’s pathetic.”

* Lake Elsinore’s team of private bond attorneys, its city attorney and its outside financial advisers get fees that amount to about 2% of the amount of each bond issuance. But because the city issues the funds for each project twice, about 4%, or $280,000 in fees, have actually been extracted from the $70-million bond total.

If the city issued all $500 million of the bonds, that would amount to $2 million in fees. One of the firms with the most to gain is First California Capital Markets Groups of San Francisco, whose chairman has helped devise Lake Elsinore’s bond strategy.

Experts told The Times that the fees being paid by Lake Elsinore are almost twice what other cities have agreed to in similar circumstances. City leaders said they are pleased with the work of First California and the other bond specialists.

* Lake Elsinore’s bond coordinator, Wood, was fired or resigned from finance positions with three Southern California cities in October, 1987, because of millions of dollars of failed securities investments. Wood was fired from Lawndale and San Marino and resigned from Palmdale after officials learned of the losses--roughly $8 million of which have yet to be recouped.

The earlier investments involved Wood’s purchases of government treasury bonds through so-called margin accounts, whereby an investor may buy securities with money borrowed from a stock brokerage.

Wood said he believes that the failed investments are irrelevant to his present role in Lake Elsinore, where Wood was hired in August, 1988, part of a local-government career that he said dates to 1948.

“That whole thing is over and done with,” said Wood, who attributed the $8 million in losses to having “misjudged the character of the broker I was dealing with.”

Records show that the United States Securities and Exchange Commission in 1989 permanently barred from stock trading two of the brokers directly responsible for handling Wood’s investment accounts for the three cities.

Mayor Washburn said the Lake Elsinore City Council was aware of Wood’s departures from the three cities when he was hired in 1988. “We reviewed it and we felt it wasn’t anything that should be a black mark against him,” Washburn said. “ . . . We feel he’s doing a good job for us.”

* Lake Elsinore entered the $14.1-million bond issue with the savings and loan that owns Tuscany Hills even though the S&L;’s annual report at that time showed it was strained and facing pressure from federal regulators.

The annual report--made public in March, 1990, 10 months before Lake Elsinore issued the $14.1-million bond for Tuscany Hills--described in detail the problems:

Homestead did not have enough capital to meet “minimum” federal requirements. Regulators had barred Homestead from accepting brokered deposits or “rolling over” its existing brokered deposits. If Homestead strayed from strict compliance with those and other operating conditions, the S&L; was at risk of being seized by the regulators.

Such a federal takeover, said the annual report, “would raise substantial doubt about the company’s ability to continue as a going concern.”

Bert Ely, a nationally recognized banking consultant, said Homestead’s annual report should have struck fear in Lake Elsinore. “The alarm should be, ‘Are we in bed with a viable entity?’ ” said Ely, who is based in Alexandria, Va.

Mayor Washburn told The Times, “I wasn’t aware of any problems they were having.”

Wood, however, said he was aware Homestead Savings was under strain when the $14.1-million Mello-Roos bond was issued in January, 1991. Wood said a letter of credit, whereby another financial institution pledges to stand behind a customer, was not sought from Homestead.

But he insisted that the city took a “conservative” approach by forming Tuscany Hills as an isolated bond project instead of packaging it with adjoining projects that could later entangle other landholders.

“We wanted to do it in such a way that if they (Homestead officials) got involved with the RTC (placed under control of the federal S&L; regulatory agency, the Resolution Trust Corp.), that it would be standing alone by itself up there,” Wood said.

Homestead’s most recent annual report, made public in April, three months after the Tuscany Hills bond issuance, called 1990 “the company’s most difficult” ever.

The report attributed Homestead’s worsening condition to “a falling real-estate market (and) recessionary economy” that “made properties more difficult to sell.”

In an interview, Homestead Savings President Charles J. Vaughan said the Burlingame-based thrift remains short of the federally imposed minimum capital requirements and is still trying to sell its remaining real estate--including Tuscany Hills.

* Lake Elsinore has allowed developers participating in the bond issuances to select the teams of private specialists that prepare the bonds--including the appraisal firm that valued the land at Tuscany Hills that is collateral for the $14.1-million bond.

“That’s a total conflict of interest,” said Clark, who along with a half-dozen other experts contacted by The Times said an independently authorized, conservative appraisal is crucial because the bonds are secured by the land value.

“Whether that land value is there is a matter of an appraiser’s judgment,” said Misczynski, of the Senate research office. “The question is, what is the value of the land when it is sold as one bloc, in a hurry, in a recession?” The state Debt Advisory Commission said in a recent report that it is “imperative” for local governments to select “competent, ethical” appraisers and all other members of the bond-issuance team.

For his part, Wood said that although he believes that the value of the land at Tuscany Hills may have dropped by half since it was appraised, he is confident the property, along with reserve funds, would be enough to repay the $14.1-million bond debt.

“I’m comfortable with the way it’s structured, that we have no problems with it,” Wood said, adding that under a “worst-case scenario” Lake Elsinore would foreclose on Homestead’s raw land at Tuscany Hills. Other developers, he said, would then be willing to buy the land from the city and assume the burden of paying the taxes that retire the bond debt.

Wood said he believes that the appraisals performed for Tuscany Hills and other projects will prove solid should foreclosures become necessary. Wood said the city’s best “safety valve” is its requirement that each bond be secured by land appraised at a value that is at least three times greater.

“Tuscany Hills, as of this time, went in at (a land value to bond ratio of) 10 to 1,” Wood said. “And even if you take some deflated values, as a result of the economy, it’s still 5 or 6 to 1, we figure.”

More than anyone, Wood said, he is responsible for fostering this city’s push to attract development by using the huge Marks-Roos pool of municipal bond money. Wood, a certified public accountant by training, remains optimistic.

“It’s an excellent vehicle because it provides, in effect, lower interest money than they (developers) can get in the private market,” Wood said, adding that the presumably lower interest expenses could mean commensurately reduced prices for home buyers.

Despite a regional downturn that has seen his city’s work force reduced by 28% this year, Wood envisions a Lake Elsinore that by decade’s end will grow to 100,000 residents, more than five times its current population.

“We don’t think the slowdown is as great here in Lake Elsinore right now as it might be elsewhere, for many reasons, not the least of which is the prices,” Wood said in an interview. “You can go up there (to the new, Tuscany Hills development) and buy a 3,000-square-foot home on a 7,200-square-foot view lot, for under $200,000.”

Wood rejected suggestions that Lake Elsinore has been too aggressive, its bond-financing controls too lax. He pointed to what he regards as this additional safety valve:

The city structures its Mello-Roos bond tax formulas in a way that extracts two years’ worth of debt payments at the time the bonds are issued. That way, if a planned development flops, the city will have the money to make the special tax payments for two years.

However, the California Debt Advisory Commission and others have noted that such a hedge against a development’s failure also drives up the property taxes of the people who buy homes in the development because they must compensate for the extracted bond proceeds.

“We have tried to take the steps here to ensure that every (bond) is conservatively issued and is properly controlled,” Wood said. “ . . . We’ve tried, and are trying and will continue to be just as conservative as we can, on all of these things.”